Making Investing too Difficult: The Fed

Thirteen months ago there was a lot of publicity about how it was impossible for the Fed to achieve what many call a "soft landing" and we like to call the "glide path."  There was some market research circulating showing that the Fed had an impossible problem.  We showed the errors in that research in a mid-August 06 article.  Mostly, the researchers reached far back in time to include the Great Depression as evidence that the modern Fed could not succeed.  There was no notice or recognition of our observations at the time.

When these dubious studies got even more circulation, we emphasized the error in two more articles (here and here).

In February, we pointed out that following this flawed research was the biggest mistake of 2006.

Since August of last year the S&P and the Dow are up over 20%, the NASDAQ composite is up 28%, and the popular NASDAQ 100 is up about 36%.

This was an easy 25% to make as long as you did not fall into the big trap.  We hope that regular readers joined us in celebrating a big day.

Is Everyone an Expert?

During this thirteen month period, the economy has experienced a rise in oil prices to new highs, the (expected) problems in the housing market, and the (somewhat unexpected) spillover into other credit markets.  Anyone knowing these developments last August would have been even more negative about the chances that the Fed would succeed.

At some point the skeptics should look at the actual evidence.  After  many weeks of pontificating by those who purport to know more than Ben Bernanke, it is time to reconsider.

At "A Dash" we have an unusual viewpoint.  Unlike everyone else, we do not claim to know more than the experts.  Instead, we try to determine the real experts.  Being modest can help your portfolio.

Your Favorite Pundit versus the Fed

Here are a number of relevant facts to help investors in finding the real experts:

• Your favorite pundit is  not smarter than Ben Bernanke.  He was a Professor at Princeton and he had front-line policy experience in government.  None of the people that you are listening to could have gotten either one of these jobs.  They write blogs or run hedge funds.  They are good at parsing anecdotal information and making trading decisions.  They are not experts at economic policy.  If they claim to be good because they have not studied economics, that is a red flag.
• Your pundit does not have the colleagues of Ben Bernanke.  Bernanke gets the advice of a group of Fed Governors who have similar credentials to his own.  The pundit consults fellow bloggers and other pundits.
• Your guru does not have the staff of Ben Bernanke.  Bernanke has about 350 economists at various Fed installations.  They are all extremely intelligent, committed to what they do, and spend all of their time on specialized issues.  No pundit comes close.
• Your pundit does not have access to advanced econometric models.  Ben Bernanke does.  That is why the pundits see everything in black and white and construct "rigorous analysis" that consists of long chains of binary effects.  Real economists think in terms of supply and demand curves and look for marginal effects.
• Your pundit introduces all sorts of extraneous arguments with fancy names.  He imputes motives to the Fed related to asset pricing, creating and pricking bubbles, moral hazard, the Greenspan or Bernanke put, and other considerations.  The Fed, according to all reported accounts, does not attend to these issues.  Their mission is to balance inflation expectations (not backward-looking data) and economic growth.

If you had a visit from an appliance repairman, or took your car into a mechanic, you would probably listen to the advice.  Economic policy is much  more challenging.  Think about it.  Where is your edge in listening to those without the strongest credentials?

Disrespect for the Fed

We are amazed -- almost daily -- by the barrage of Fed commentary by those with little expertise.  Apparently it makes the pundit seem sophisticated to talk about "Greenie" or "Uncle Ben" or "Helicopter Ben" or such.  Meanwhile, those who actually read and study the Fed have an advantage.  It is not difficult.  Pay attention to former Fed Governors like Wayne Angell, Laurence Meyer, (frequently cited here), and Robert McTeer.  Tune out the others.

Pay attention to public speeches, which provide background and reasoning, but not actual policy.

The Fed deliberations and communications are much more transparent than in the past.  This is not a Hollywood conspiracy with secret, unstated motives.  Former Fed members write memoirs, write blogs, give speeches, and appear frequently on CNBC.  Those of us who watch these sources for clues may seem naive to the pseudo-sophisticates who think they are smarter and wiser.  In fact, these sources have provided a better insight into what is really happening. 

What Next?

Investors have a clear choice.  The (consistently wrong) bearish pundits assert that the Fed is either panic-stricken and "behind the curve", caving in with an excessive rate reduction, or creating a new round of inflation.  These pundits all agree that the Fed has it wrong -- but their policy prescriptions are completely different!

Alternatively, one might conclude that the Fed has done a good job, and continues to do so.  Their read on the economy is that it is still solid, but they accept the warning signals of problems.  They are not merely looking at past data, and they are not focusing on a specific report.  They are using a wide range of information -- government reports, private reports, consultations with those in financial markets, and anecdotal evidence from Fed Districts -- to look ahead.

The interest rate reduction -- in their view -- is pre-emptive, not reactionary.

The Fed is looking  forward.  If they continue in their successful path, there is plenty of opportunity ahead.  Corporate earnings continue to beat estimates.  Viewed on a forward earnings basis, major US equities are attractively valued.

Comments

[oldprof]

Bob, Ames, and Bz:

I'm going to take the risk of responding to all of you together, but feel free to comment further.

First off, I appreciate anyone who reads "A Dash" and makes a thoughtful contribution. Disagreeing with my viewpoint and pointing out my errors are both just fine.

Bob: You have posted an indictment of econometric methods that says, basically, that they are not perfect. I think most readers would disagree with the conclusion that we have bounced from crisis to crisis.

As to the book, where you have posted a lot of PR by the authors themselves, you raise an interesting question. I have a tall stack of things to read. This is a 1600-page novel that is supposed to educate me. I have no objection to the form -- Michael Crichton does it all of the time.

Do you go to a movie without checking out the reviews? I don't. I quit wasting my time many years ago, and books are the same. The problem with this work is that it is endorsed by what might be viewed as a cult following. Feel free to inform me of reviews that I missed. I admit that my own experience with government, both academic and personal, makes me very suspicious of the descriptions of institutional behavior and motivations of the participants.

Ames and BZ - You are correct in noting that the Fed is opting to emphasize economic growth. If you check out past posts on this site, you will see comments on both the balance of trade and inflation.

If the Fed, we could have a stronger dollar, no inflation, and a depression.

There is a place for debate over economic theory -- Austrian economics, Friedman, inflation targeting. These have all been subjects during my academic and investing life.

Meanwhile, I am trying to help people make better investment returns in the reality of the current institutional framework.

I look at institutional behavior. I want to know what THIS FED will do, not what Hayek or Friedman would have done.

It does not mean that I think they were wrong -- just that it is not relevant to the current problem.

I very much appreciate your comments, since they help to clarify one of our purposes.

Perhaps I should make this into a separate post.

Thanks,

Jeff

[oldprof]

Catching up on some comments after a few days of fighting fires of the non-blog type :)

Bill: Your (ongoing) complaint about the way I use the terms inflation and deflation is (once again) duly noted for the record! :) I'm not the only one and I'm probably not going to change this particular shorthand, but I want to acknowledge your point.

Thanks,

Jeff

[bz]

If you think losing 98% of the value of the dollar since 1914 is success then we are in trouble

[Ames Tiedeman]

We cannot sustain 800 bilion a year trade deficits. We cannot export our way out of this mess. The only answer is a sharply lower dollar to drive manufactruing home and to lower the trade deficit. The dollar has much farther to fall. What you are seeing is a long term effort (it will take 20 years) to get the trade deficit back under 1% of GDP. We are currently running a trade imbalance of nearly 6% of GDP. No nation can do this. The IMF would be stepping in to help any nation if its trade impalance went to 6% of GDP becuase its currency would collapse! The U.S. is different, but still we cannot sustain a trade deficit of this magnitude. People must understand, when we buy an item from say China, we pay in dollars. The Chinese company we just bought from them goes to an Exchange Bank in China and converts those dollars to Yuan. The Chinese banking system (Chinese Government) is now sitting on the dollars. They can either 1, buy oil, 2, buy Treasuries, 3. buy U.S goods, 4. buy U.S. Corporations, 5. other. Over time if we (the U.S. ) contiue to run a trade deficit we could simply be completely bought and controlled by foreigners. Warren Buffet has explained the situation as being like a rich Texas farmer who loses a small piece of his land year after year and never notices for a while. When he then notices, tragedy sets in because he no longer controls his land. So in sum, we need to get the trade deficit way down. This is why the Fed has abandoned the dollar. It wil be going down for the next 20 years. That is how long it is going to take to correct this imbalance mess.

[bob]

Yeah right, Jeff, the Fed has lots of "experts", that's why we go from one bubble/crisis to the next, and each one getting bigger and bigger. The government has even a lot more "experts/gurus" in many branches, so why do they screw this country up left and right?

You're dreaming if you think 1,000 (or even 10,000) economists with their fancy models at the Fed are smarter than the markets. Mathematical models can never decipher human behavior and psychology, which is an integral part of the markets. Remember recent "quant funds" debacle?

The .50 cut was a blatant bailout of Wall Street's bankers. The long term yields shooting up means mortgage rates are going up, not down. So does that benefit the people with mortgages they can't afford in the first place? And does lower interest rates help people with their bank deposits? It's obvious who benefit from the rate cuts, and it's not the average American.

Not only that, gold and other commodities' price shot up (including food/gas and other daily necessities) -- I guess that really helps the low/middle income people. And the dollar tanked, great work. Now only the rich can travel abroad.

During the Clinton years, the dollar appreciated ~50%, and all the gain got wiped out since 2000. Ah yes, where did all the national surplus go since? Now we have huge deficit. This is not exactly the Fed's problem, but it goes to show how so many supposedly experts and gurus in the government can screw up big time. Remember the wonderful years of Carter?

If you haven't read the following book, I recommend you to (unless you've already known some of the facts mentioned in the book, but for one reason or another, don't want to admit/mention them):

CRA$HMAKER: A Federal Affaire
by Victor Sperandeo & Alvaro Almeida
Two Volumes— Preface plus 1,572 pages— Hardbound
Library of Congress Catalog Card Number: 99-93805
ISBN: 0-9671759-0-9

Excerpt:

“…The Fed’s real purpose— its hidden agenda— is to facilitate government spending through inflation. To avoid imposing politically intolerable levels of taxation to pay for the spending that returns them to office election after election, politicians rely on the Fed to confiscate wealth from the public through inflation. Inflation’s a hidden tax, and lessens the cost of borrowing by enabling the government to pay its debts in depreciated currency.”

Of course he nailed it. Sadly, many people (I used to be one of them, not anymore) still think the Fed is the white knight who "rescues" this country every time we go through a financial/economic crisis. The Fed is the cause of most of these crises, not the solution. Milton Friedman knew that. And that's why Bernanke admitted (on Milton Friedman's Ninetieth Birthday):

"Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."

Wow, thousands of "experts/gurus" at the Fed screwed up big time and didn't even know it, until one man pointed out their mistakes. Don't be so shallow/prejudiced as to totally discard the collective knowledge of bloggers out there. They might not have Friedman's brilliance (some don't even have the right knowledge/information), and any single one of them can hardly be argued to be more knowledgeable than the collective brain of the Fed. But that doesn't mean they can't offer certain valid and useful ideas and/or information that the Fed can learn from.

Not only that, being smart/knowledgeable is not a guarantee that one can make the right decision every time. Many times the popular, well-accepted opinions of so-called experts turned out to be false. Who would have thought the Wright Brothers were right, they instead believed all famous scientists at that time who declared we could never fly?

Albert Einstein, 1932
There is not the slightest indication that nuclear energy will ever be obtainable. It would mean that the atom would have to be shattered at will.

Hewlett Packard excuse to Steve Jobs, who founded Apple Computers instead.
We don't need you. You haven't got through college yet.

Thomas J. Watson, chairman of the board of IBM.
I think there's a world market for about five computers.

Western Union memo, 1876
This 'telephone' has too many shortcomings to be seriously considered as a means of communication.

Irving Fisher, Professor of Economics, Yale University, 1929, right before the great crash:
Stocks have reached a permanently high plateau.

...

Gosh, I sincerely wish that the Fed will never drive this country into another depression again, one way or another. There's no such thing as a "free market" when interest rates can be manipulated at will (I guess the legal term is "regulated") by just a few people.

Again, Friedman was right on:

"Any system which gives so much power and so much discretion to a few men, [so] that mistakes — excusable or not — can have such far reaching effects, is a bad system. It is a bad system to believers in freedom just because it gives a few men such power without any effective check by the body politic — this is the key political argument against an independent central bank...
To paraphrase Clemenceau, money is much too serious a matter to be left to the central bankers."

For further references on the recent crisis: http://articles.moneycentral.msn.com/Investing/SuperModels/AreWeHeadedForAnEpicBearMarket.aspx

Lots of people have already talked about "moral hazard" so I don't want to go into that. The thing is, when the house is burning, you don't ask who started the fire, you concentrate on saving it from being ruined. The problem is: after the house is saved, the people who started it never got questioned/punished/penalized. Not only that, they thrived afterwards.

Guess what, the next time they'll start a bigger fire in a bigger house. We've all seen this movie before. When things go well, Wall Street privatize their profits/bonuses. When crisis happens, they want the government to socialize their losses at taxpayers' expense.

It's a "free" market alright, but it's only free for Wall Street's billionaire parasites. I hope the next big fire in the next big house (inevitable) won't be too big to be distinguished before the house got burned down totally.

Despite all these gloomy facts/views, I'm still an optimist. I still have hopes for this country with its (generally) great people. You seem like a decent guy. But be careful with your "facts" and views. Otherwise, the "Insight" in the blog's title might be regarded as nothing more than shallow, snobbish naiveness.

[RB]

er... maybe that should read obscure, not obtuse.

[RB]

You are kind but since the active part of my investing is just about a year old, I don't claim to any level of expertise.
While Bernanke may be less obtuse than Greenspan as a Fed, interpreting Fed speeches still appears to be an art. As an example, while Bernanke@Berlin talks about long-term interest rates, which are currently low according to his savings glut hypothesis (Roach calls it a shift in the savings mix from developed to developing instead), will adjust higher slowly over the decades, Greenspan thinks it might be more short-term and that Bernanke really doesn't have any evidence to up his more benign outlook.
http://uk.us.biz.yahoo.com/ft/070916/fto091620071517233543.html?.v=1

There's an interesting clip of Greenspan at Comedy Central at crossingwallstreet.com. In it, he states (probably philosophically) that forecasting today is no better than it was fifty years ago.

[oldprof]

RB

The Fed uses many data sources. I have not seen anything to suggest that they place any emphasis on the stock market as a leading indicator. Wayne Angell said yesterday that before voting, they go around the table and everyone speaks. Meyer said the same in his book. Lots of information, lots of sources, with everyone trying to look ahead.

You are correct in citing the shift in the Malpass viewpoint, something I take seriously. I noted the shift in his position in this post:
http://oldprof.typepad.com/a_dash_of_insight/2007/09/housing-effects.html

The statement is the result of a committee. The individual views will be further clarified. You are obviously a sharp observer, and you have raised a question about transparency to which many would like an answer.

The problem is that many of those posing this question (not you, but some) would be suspicious no matter what the Fed did. If they do little, they are "behind the curve." If they act more aggressively, it is panic.

Many analysts reach an opinion about the Fed based upon their own economic and market opinions. This is backwards.

Thanks again for another stimulating question.

Jeff

[Bill aka NO DooDahs!]

I'm sure you mean "global falling asset prices" and not really "global deflation," since inflation and deflation are monetary phenomena, and deflation ain't gonna happen in a fiat currency world.

[oldprof]

Mike-

I am delighted that you are reading regularly and I welcome your frequent and thoughtful comments.

Concerning Greenspan: As he does his book tour, we see all of his positions and statements under a microscope. The most important criticism - keeping rates too low for too long - is something we'll never really know. I have an article or two in mind about the concept of the "counterfactual" but I have not gotten around to it. Basically, we do not know what would have happened had he not fought the threat, widely perceived at the time, of global deflation.

The Fed officials regularly tell us that they focus on the economy, not asset bubbles. I am not going to do some detailed defense of Greenspan, but I believe that history will (and should) treat him kindly.

Mistakes? Sure! Even intelligent, well-advised, experienced decision makers can go wrong. I just think the skepticism about the Fed is way overdone.

Thanks again,

Jeff

[RB]

I admit to being puzzled as to how to interpret this on a Fed model valuation basis. If the market is already significantly undervalued as described here even after accounting for earnings contraction
http://oldprof.typepad.com/a_dash_of_insight/2007/02/investing_for_2.html

and the market is seen as one of the leading indicators for the economy, why the rate cut? I don't believe a recession is likely currently but it is worth acknowledging that just a couple of months ago Malpass, one of the experts cited here frequently, was calling for two or three rate hikes. To me the question is this -- is the Fed being entirely transparent about their concerns?

[Mike C]

Jeff,

Your blog has joined my list of must read blogs. You are an excellent writer, and most importantly you stimulate thinking.

I often find myself disagreeing with your argument, yet I find you force me to rethink my position.

Just curious, presumably Alan Greenspan fit all the criteria Bernanke does in your post here. Intelligent, with access to expert colleagues and staff, and the most advanced econometric models.

Yet he (Greenspan) himself has stated he was late in recognizing the situation in subprime. He continues to maintain he did NOT make a mistake in keeping rates as low as he did for as long as he did, but if that isn't the case, then what was responsible for the degree to which housing prices and the amount of credit for housing got out of hand. I believe it was Greenspan himself who was encouraging the average Joe to take out the ARM mortgage which is presently a source of problems.

I'm sure that I do NOT know more then the "experts", but I think it could also be a mistake to assume that the expert decisions and actions are automatically correct. They are fallible human beings as well.